Tuesday, September 15, 2015

Lesson 10 The Value of the Dollar is the Steve Martin of EconoWorld

Steve Martin is a wild and crazy guy. So is the value of the dollar. There is much being said about the value of the dollar of late. So I thought I would look at it a little more.  My conclusion is that it is wild and crazy. That means that undo concern about recent highs in the value of the dollar could be misplaced. Here today gone tomorrow might be apt.  Let’s see what you think.

But first, let’s admit that the value of the dollar is an elusive concept. You have a dollar in your hot little hand. What is its value? In buying a JD, one measly dollar is worth a drip or two. Or a dollar might get you a really large handful of red jelly beans. Point – the value of the dollar depends on what you are buying. When it comes to domestic spending we have something called the Consumer Price Index. We use it to judge how much a dollar will buy in terms of all the goods and services consumers usually buy. No Charlie – it does not include pole dancing.

When the prices of things you usually buy rise quickly you lament that the value of your dollar is going down. When prices fall, you are happy that your dollar stretched further.

The above is all correct but it mostly pertains to spending on domestic goods and services in the US. There is an international aspect of the value of the dollar because in order to buy things abroad, you first have to buy foreign currency. So we talk about the value of the dollar as it relates to buying euros, yens, or loonies. If today I can get more euros or yens or loonies with my pretty green dollar – then today I say that the dollar strengthened – the value increased.

Since we trade with many nations, we are concerned with how the dollar’s value is changing with respect to an average of the currencies of our main trading partners. Those main trading partners include Mexico, Canada, China, the UK, the Bermuda Triangle and more. The Trade Weighted U.S. dollar measures how the dollar is faring against the currency values of our main trading partners.

So let’s call the value of the dollar – TWMTP. If you want to say it out loud – say TwaMooTooPoo. But have at least one JD before you try to say that. Below is what I learned about the value of dollar by looking at the data from 1973 to 2014. In 1973 I was starting my PhD program at UNC and my son Jason was born. But that is a whole other story.

In January of 1973 TWMTP had a value of 108. As of July 2015 it was 92. A lot of JD has gone under the bridge during those 42 years. I will say more about some of those years – but my first point is that at 92 – the dollar fell by about 15%  relative to 1973. So if someone tells you that the dollar is very strong right now you can look her in the eye and say – compared to when Jason was born, the dollar weakened by 15%. No offense meant to Jason. 

There must be more to the story. In April of 2011, TWMTP was 68. That was pretty low. In the past four years the dollar recovered to 92. So you could say --  okay smarty pants the dollar appreciated by 35% in the past four years so the dollar is strengthening. The dollar is clearly high and strengthening during the past four years. This is behavior that has some people bothered. A 35% appreciation seems bad to them – but where is it going to go from here?

Future exchange rates are not easy to predict.  The annual mean change of TWMTP over the last 42 years was -0.4%. If you use the past mean as a predictor of the future, then it says you predict no change next year – or zero percent. In those years since 1973, the dollar increased in 19 years and it decreased 22 times. The annual standard deviation was approximately 6%. That’s pretty wild and crazy. And the range of those annual changes was impressive. TWMTP rose by a high of 10.5% in 1982. It fell the most in 1986 when it depreciated by 18%. Now that is a roller coaster. So if our worry and consternation is about a high and rising value of the dollar in the future – our recent bout of appreciating dollars may or may not have much staying power.

But that isn’t the whole story. Within that 42 year span, there have been some long waves of exchange rate change.  Check out these waves (please don't get sea-sick):
            Jan 1973 to June 1980       -14%
            June 1980 to Feb 1985      +56%
            Feb 1985 to March 1995   -44%
            March 1995 to Jan 2002   +36%
            Jan 2002 to April 2011     -62%
            April 2011 to July 2015    +35%

These long waves of change lasted as long as a decade! Of course during any of these longer time periods the value of the dollar wriggled up and down often.

This background helps us phrase the question about the future. Yes the dollar has increased in value during the last four years. Does that mean we are on a long wave of dollar appreciation? The dollar is 35% higher than in 2011. But notice at 92 it is still well below the 110 that prevailed in January of 2002 and the 108 that existed in 1973. In fact the current reading of 92 is lower than approximately half of the years between 1973 and 2015.

Since the statistics give us little to bet on in the way of future changes in the value of the dollar – that leaves us with theory.  So long as our trading partners struggle and we look like an attractive investment location – it's hard to imagine the dollar falling in value very much. But how long can that continue? Is US policy that good and foreign policy so terrible that global investments will keep flowing to dollars and US investments? It seems not so long ago that the reverse was happening. We were worried that the yuan and the euro would steal the dollar's thunder. 

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